Mission Concluding Statement 

Malta: Staff Concluding Statement of the 2016 Article IV Mission

December 16, 2016

Malta’s economic growth has been exceptionally strong. Sound policies and favorable external and domestic conditions have led to robust employment growth and an improvement in public finances. Looking ahead, the key policy challenge is to sustain the high growth and make it more inclusive in an increasingly uncertain external environment. Efforts should therefore focus on further enhancing the economy’s resilience to shocks, and addressing the remaining structural impediments.

1. Robust economic activity is projected to continue, albeit at a more moderate pace . Domestic demand-led GDP growth is projected to reach about 4 percent in 2016 and stabilize at a potential rate of 3 percent over the medium term. Strong job creation is expected to continue in the coming years, keeping unemployment low. Inflation is set to increase modestly as import prices recover while sizable services balances will continue to support current account surpluses.

2. However, external downside risks predominate. Malta’s high openness makes it vulnerable to a weaker external environment and rising anti-globalization sentiment in large economies. Uncertainties surrounding the Brexit negotiations could weigh on economic activity through both direct and indirect exposures while EU-wide corporate tax reform may impact unfavorably Malta’s economy. Domestically, recent structural reforms could have a stronger-than-expected positive effect on growth. While data do not point to a misalignment of house prices at the current juncture, persistence of upward trends in mortgage lending and the housing market may lead to imbalances, amplifying risks to financial system and the broader economy.

Building buffers and managing fiscal risks

3. Further fiscal consolidation is expected in the near term. Robust growth and adjustment measures are expected to bring the 2016 fiscal deficit down to 0.7 percent of GDP, well below the budget target. The 2017 deficit is projected to decline modestly to 0.6 percent of GDP on the back of higher excise taxes and lower public spending, resulting in a structural adjustment of 0.4 percentage point of GDP. This adjustment, along with favorable economic conditions, will support a reduction of public debt to below 60 percent of GDP.

4. Well-specified measures should underpin the medium-term consolidation plan. Achieving the medium-term objective of a structural fiscal balance will put public debt on a firmly downward path while sustaining the positive economic momentum. However, policy measures should be better specified. Priority should be given to containing the fast-growing wage bill and intermediate consumption, including by building on the recommendations of the recent in-depth spending reviews and conducting similar reviews for the broader public sector. Ongoing efforts to enhance tax collection efficiency would support the fiscal adjustment while creating space for growth-enhancing policies.

5. Improving the financial health of state-owned enterprises would reduce fiscal risks. The restructuring of Enemalta, the main provider of electricity, has led to efficiency gains and supported the company’s return to profitability. Meanwhile, the recovery of Air Malta is lagging behind and, although financial performance has improved recently, the company continues to generate losses. A faster restructuring of Air Malta is needed to contain fiscal risks. At the same time, Enemalta’s elevated government guaranteed debt calls for continued close monitoring of its operations.

6. Long-term spending pressures should be contained . Recent steps to reform the pension system are commendable given long-term demographic pressures. Additional measures to align the effective retirement age with life expectancy, better link pensionable income to life-time earnings, and lengthen the contributory period would further mitigate the associated long-term fiscal risks. Continued efforts to incentivize voluntary long-term savings would help ensure socially sustainable pensions.

Safeguarding financial stability and improving access to finance

7. The banking system appears sound and resilient, but faces a number of challenges. Domestic banks report adequate capitalization and liquidity, and profitability above levels seen in peers. However, headwinds from protracted low interest rates, weak credit growth, and legacy non-performing loans (NPLs) in the corporate segment pose challenges. Furthermore, future regulatory changes and uncertain external environment, including from the Brexit decision, may affect banks’ profitability prospects and their capacity to support growth. High and increasing exposure of banks to the property market may increase financial stability risks.

8. The resilience of the private sector needs to be bolstered further. Deployment of targeted macro-prudential tools linked to mortgage lending would enhance banks’ and households’ resilience to possible property market swings. Closing data gaps is critical to calibrate such measures. A careful review of the fiscal incentives related to property market together with measures to address housing supply bottlenecks would help avoid imbalances in this market. Furthermore, a faster resolution of legacy NPLs would strengthen private sector balance sheets and unlock resources for growth. In this regard, the recent regulatory changes, which require banks to submit time-bound plans to reduce their NPL ratios, and efforts to streamline legal proceedings would foster the resolution of distressed loans. While supervision is effective, it is important to ensure the availability of adequate resources in light of the growing size of the financial sector.

9. The planned Malta Development Bank (MDB) could support the economy but fiscal risks should be contained . The strategy for the future bank aims at increasing banks’ lending to credit-constrained SMEs and providing co-financing for large development and social projects. Nevertheless, it is critical—as intended by the authorities—to ensure that MDB’s operations will lead to new credit origination by banks to viable firms rather than evergreening existing exposures to distressed borrowers. Robust governance structure, prudent risk assessment, adequate supervision, and well-designed origination rules are critical to mitigate contingent liability risk to public finances.

10. Ongoing vigilance is needed to contain risks to the integrity of the financial system. In view of the high demand for Malta’s Individual Investor Program and the rapid growth of the remote gaming and financial services, it is important to continue with close coordination between the involved regulatory institutions, provision of adequate resources for inspections and training, and a robust implementation of the Anti-Money Laundering/Combating the Financing of Terrorism framework in line with the 2012 Financial Action Task Force’s standards.

Boosting productivity and making growth more inclusive

11. Steady reform implementation will support high and inclusive long-term growth. Continued reform momentum—consistent with the government’s national strategy—would help address the remaining structural impediments, close the income gap, and ensure a more equitable distribution of growth dividends. In particular, sustained efforts are needed to:

• Increase the labor force participation. Recent measures supporting female labor force participation continue to bear fruit. Further actions are needed to integrate the remaining inactive population, particularly women, into the labor market. Expanding labor activation policies, and enhancing education quality in line with the recently completed in-depth review, would reduce skill mismatch in the face of the changing labor demand. Further incentivizing delayed retirement would boost labor force participation among the elderly.

• Enhance SMEs’ innovation . Higher R&D activity would boost productivity growth and competitiveness. Strengthening firms’ balance sheets and broadening SMEs’ non-bank and equity financing would alleviate financing constraints, including for innovative projects. Increased public R&D spending as a share of GDP towards the EU average, close partnerships with education institutions and improved access to foreign markets would complement these efforts.

• Streamline the legal process . Recent measures to speed up the settlement of civil and commercial cases will strengthen the business environment. Completion of ongoing work to address the shortcomings of insolvency and bankruptcy frameworks would improve contract enforcement and allow a faster resolution of balance sheets problems.

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  The mission would like to thank the authorities, private sector participants, and other interlocutors for the open and productive discussions and warm hospitality.